MARKET EFFICIENCY AND MARKET FAILURE
This chapter introduced the basic tools of welfare economics=-consumer and producer surplus-and used them to evaluate the efficiency of free markets. We showed that the forces of supply and demand allocate resources efficiently. That is, even though each buyer and seller in a market is concerned only about his or her own welfare, they are together led by an invisible hand to an equilibrium that maximizes the total
benefits to buyers and sellers A word of warning will order, To conclude that markets are efficient, we made several assumptions about how markets work. When these assumptions do not hold, our conclusion that the market equilibrium is efficient may no longer be true. As we close this chapter, let’s consider briefly two of the most important of these assumptions First, our analysis assumed that markets are perfectly competitive In the world, however, competition is sometimes far from perfect. In some markets, a single buyer or seller (or a small group of them) may be able to control market prices. This ability to influence prices is called’ market power. Market power can cause markets to be inefficient because it keeps the price and quantity away from the equilibrium of supply and demand.
Second, our analysis assumed that the outcome in a market matters only to the buyers and sellers in that market. Yet” in the world, the decisions of buyers and sellers sometimes affect people who are not participants in the market at all. Pollution is the classic example, of a market outcome that affects people not in the market. Such side effects, called externalizes, cause welfare in a marker to depend on more than just the value to the buyers and the cost to the sellers. Because buyers and sellers do not take these side effects into account when deciding how much to consume and produce, the equilibrium in a market can in efficient from the standpoint of society as a whole.
Market power and externalities are examples of a general phenomenon called market failure-the inability of some unregulated markets to allocate resources efficiently. When markets fail, public policy can potentially remedy the problem and increase economic efficiency. Microeconomists devote much effort to studying when market failure is likely and what sorts of ‘policies are best at correcting market failures. As you continue your study of economics. you will see that the tools of welfare economics developed here are readily adapted to that endeavor Despite the possibility of market failure, the invisible hand of the. marketplace is. extraordinarily important. In many markets, the assumptions we made in this chapter work well, and the conclusion of market efficiency applies directly. Moreover, our analysis of welfare economics and market efficiency can be used to shed light on the effects of various government policies. In-the next two chapters, we apply the tools we have just developed to study two important policy issues-the welfare effects of taxation and of international trade.